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Cisco: Undervalued and on the Move Again - P/E Very Rational

At the peak of the dot.com boom Cisco became the world’s most valuable company at roughly $550B. Investors couldn’t get enough Cisco and drove its market cap skyward to 5X where it is today– just under $100B as of this writing.

Subsequent to that bubble bursting, enterprise tech has been a mixed bag with stalwarts such as Microsoft, Intel and Cisco trading in a disappointing range for investors. Consider that Intel and Microsoft are trading at roughly 80% of their respective values relative to ten years ago while Cisco is down around 10% in that timeframe. Meanwhile, the Nasdaq composite is up more than 30% in that same period with Oracle up more than 100% and EMC up around 40%.

Cisco went on an enormous buying spree in the mid-2000’s, trying to diversify into video and consumer markets to expand its total available market (TAM) and accelerate growth. The firm picked up Linksys for $500M and then followed that up with a giant $7B acquisition of Scientific Atlanta, a consumer video and data services company. Then there was Webex for $3.2B, which is driving the company’s collaboration business. In 2009, Cisco bought Pure Digital for nearly $600M. In a sign the company got too far out over its skis, earlier this year it killed the Flip camera business enabled by the Pure Digital acquisition.

Cisco was used to 40% growth rates in the 90’s and the acquisition strategy was designed to keep the company growing at a 15% clip. Despite the fact that some of these acquisitions (e.g. Webex) are now $1B+ businesses, major parts of Cisco’s diversification strategy failed, particularly in the consumer video space. As such, CEO John Chambers was forced to cut back and re-focus on its current main businesses including switching and data center products, collaboration, video and services.

I’ve been critical of Cisco in the past (as has many), but they have been responding with product upgrades and reorganizations. Juniper has had an opportunity to pull close to Cisco but has been squandering that chance. If Juniper’s software approach and mobile pans out maybe they might have a chance. Now it’s clear that the the negative sentiment has bottomed and Cisco is poised to rebound. The changes in the converged networking market are clearly lining up in favor of Cisco and HP.

What’s impressive is the Cisco turnaround. Cisco has moved from their “GE-like” organization structure to more decentralized decision making. This is helping them get back on track. The company has begun to execute on CEO John Chambers’ three-year plan. In its most recent quarter, Cisco posted record revenues, had double-digit product growth and grew gross margins in a very competitive pricing environment. Cisco has a very strong balance sheet and extremely good relationships with the channel. The heart of Cisco’s business is core switching and it’s from this point of strength where the company is mounting a counter attack to companies such as HP and Huawei.

Cisco is a leader and a giant player and in that sense it views the market through big picture trends. The data center is evolving from physical hardware to virtualized systems to cloud and IT-as-a-Service. To that end the company made a major pivot in 2009 diving into the server business and severing tight relationships with HP, IBM and Dell, forcing those three to make networking acquisitions to counter Cisco’s move.

Here’s what was going on there. Applications drive hardware sales. An application head decides to buy, say, Microsoft Exchange and that sets off a chain reaction of infrastructure capital expenditures for servers, which drags storage and networking along with it. Cisco for years had very tight relationships with server vendors and their joint channels of distribution. Cisco saw the chance to make a channel play and capture more value by bundling servers and networking into a single package (Cisco UCS which includes Intel blade servers). That also set up a virtualization and cloud play through a partnership with VMware (and EMC) called VCE, which bundles VMware, networking and storage together in a package. Think of it as cloud-in-a-box.

By targeting a servers and networking as a single block of infrastructure Cisco is now selling an attractive package to the channel, doing a reach around on HP, IBM and Dell. Its server business is 100% focused on x/86 blades, which is the highest growth market. Cisco and HP have been at war about server market shares but the bottom line is in two years Cisco has captured 10% of the worldwide x/86 blade market and is now in a dead heat with IBM in the U.S. for market share in this segment. While still behind HP in servers, Cisco is redefining the category by bundling in networking. This forced HP to purchase 3Com in late 2009. Nonetheless, it’s driving growth and margin expansion for Cisco’s core data center business.

Here are John Chambers’ comments regarding Cisco’s Data Center line of business from Cisco’s most recent financial conference call (Fiscal Q1):

Results in this area have been particularly outstanding, given that we are taking on the big competitors in the data center. As we focus on this market transition with the convergence of server, processing capabilities, networking and storage into the cloud, the UCS in the data center grew year-over-year at 122% in terms of orders and 116% in terms of revenues, and is now at a $1 billion annualized revenue run rate.

Even though the Nexus 2000 and 5000 are included in our switching product summary, not the data center, they are obviously tied very tightly to the UCS. Again, you saw the Nexus 2000 through the 5000 combination orders growth of approximately 120%, and revenue growth of approximately 80%. These 2 product lines together now have an annualized run rate of approximately $1 billion.

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